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Why Whole Foods Market Inc. Should Fear Kroger Co.

Kroger is helping bring organic groceries into the mainstream. Why that's both good and bad for Whole Foods.

Kroger's (NYSE:KR) fourth-quarter earnings results were packed with good news for shareholders. At the top of the list was a 6% comparable-store sales growth figure that left rival grocers in the dust. And the 14% annual profit spike was significantly above management's initial target for the year.

There were also two numbers in the release, $1.2 billion and $3.5 billion, that could spell stress ahead for Whole Foods' (NASDAQ:WFM) investors. The first figure represents annual sales of Kroger's organic foods brand, Simple Truth. That product was launched less than two years ago and has become Kroger's most successful corporate offering. The second number is Kroger's 2014 spending on price cuts — which happens to be more than the grocer earns in profit every year.

More crowded market

Whole Foods is the leading retailer at the head of a big trend toward more healthy eating. The company even owns the trademark to the title "America's Healthiest Grocery Store." That's a nice brand position to have when organics are growing at such a quick pace relative to the rest of the supermarket world. In 2013, organic and natural sales were up 11% as compared to 3% for the grocery industry. And Whole Foods' profitability benefits from the fact that those products carry a higher premium. Gross margin was 35% over the past year while Kroger's was 21%.

Kroger might not be known as the "healthiest" shop, but it is quickly improving its organic selection. Kroger now carries 2,700 products under the Simple Truth brand, and management credits success in this category for helping it book accelerating comparable-store sales growth all year. The grocery chain even managed to outgrow Whole Foods over the last four quarters straight.

Source: Company financial filings.

Disappearing price premiumIn addition to the market share challenge, Whole Foods can expect to see more pricing pressure from Kroger. Sure, most of the $3.5 billion of annual price cuts aren't on organic food. That category is a small portion of Kroger's $108 billion of annual sales. Instead, the price competition is mostly focused on its main rivalry with Wal-Mart.

But management is aggressively using price cuts to target organic food shoppers. Here's how a Kroger executive described the strategy in a recent conference call with analysts:

"Our customers are very clear [that] they don't want to have to pay a premium for natural and organics. And we're trying to make sure that they can get a good quality product at a price that's comparable to the non-organic brands and in some cases actually the same price." — Mike Ellis

Kroger isn't alone here. Costco is working hard to bring prices down for its organic products to the point that they carry almost no premium over non-organic options.

And Kroger has an advantage over Costco's price-cutting ability in that it controls its own manufacturing plants. The grocery chain opened up a new dairy processing plant last year that produces organic milk, for example. Kroger's strategy involves using plants like that to push prices even lower. Here's Kroger's CEO Rodney McMullen explaining the idea to investors:

"Even though natural and organic foods have been notoriously out of reach for many customers, we used our merchandising expertise, manufacturing base and buying power to make them affordable and accessible to all customers."

Foolish wrapWhole Foods stands to benefit from the fact that organic and natural groceries are moving into the mainstream. That trend opens up a much bigger revenue opportunity: The U.S. supermarket industry had $620 billion of sales in 2013, and the organics portion made up just $89 billion. But to earn a piece of that larger grocery pie, Whole Foods will have to face bigger competitors like Kroger, who are used to operating on much lower profit margins.